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8/7/2019 Developments in Valuation of Healthcare Services
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Business Valuation Associationof Chicago
Developments in the Valuation of
Healthcare Service Businesses
Presented by:
ROBERT JAMES CIMASI, CBCPresident
HEALTH CAPITAL CONSULTANTS10420 Old Olive Street Road, Suite 200
St. Louis, Missouri 63141-5938(800) FYI-VALU
www.healthcapital.com
March 23, 2000 Chicago, Illinois
.
Robert James Cimasi, CBC
This presentation addresses information and developments in the admittedlybroad and rapidly changing area of business valuation as it relates to healthcare
professional practices. Neither the presenter nor the sponsor intend this
presentation to render any legal or accounting advice, but rather to provide
general information and sources. Neither the presenter nor the sponsor assume
any liability with respect to the use of information contained in this presentation.
For le al or accountin advice individuals and their irms are ur ed to consult
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Table of Contents
I. INTRODUCTION..............................................................................................................1
A.Do You Know What the Trends and Developments Are in the Healthcare Industry?........1B.Importance of a Professional Valuation...............................................................................2
II. OVERVIEW OF MAJOR HEALTHCARE VALUATION CONCEPTS &CHALLENGES..................................................................................................................4
A.Healthcare Valuation Context .............................................................................................4B.
Basic Healthcare Valuation Tenets .....................................................................................4
C.Reliance on Historical Data ................................................................................................6D.Value as Incremental Benefit ...........................................................................................8E.Scope & Nature of Valuation Engagements are Changing-Aspects to Consider .............11F.The Range of Services for Healthcare Valuation Reports.................................................13
III. INDUSTRY BACKGROUND ISSUES..........................................................................14
A.The Shifting Universe of Healthcare Delivery ..................................................................14B.Trends in Physician Supply, Workplace and Specialization .............................................17C.Changes in the Professional Practice Competitive Environment .....................................21D.Reimbursement Issues and the Transition to Capitation ..................................................27
IV. THE RISE OF EMERGING HEALTHCARE ORGANIZATIONS (EHOS)...........34
A.Types of EHOs...................................................................................................................37B.Challenges to the Valuation of Emerging Healthcare Organizations (EHOs)...................49
V. TRENDS IN HEALTHCARE TRANSACTIONS........................................................51
A.Physician to Physician Transactions .................................................................................51B.Physician Practice Management Company (PPMC) Transactions ...................................51
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Table of Contents (continued)
C.Hospital Transactions .......................................................................................................55D.Cost Containment-Regulatory Agenda is Changing the Market Terms and Structure of
Healthcare Transactions ..................................................................................................55
APPENDICES:
General Research Sources and Information:
A. Selected Healthcare Articles Bibliography
B. Emerging Healthcare Organizations Articles Bibliography
C. Valuation Books
D. Glossary of Healthcare Terms
E. Additional Sources of Information
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I. INTRODUCTION
With the rise of managed care over the last decade, the healthcare provider environment has
experienced significant and often chaotic transactional activity. Physician integration /
affiliation arrangements, practice and other healthcare entity acquisitions and mergers, and
industry-wide provider roll-ups and consolidations as well as other creative equity sharing
integration activities have often been seen as the key to the capital formation strategies
necessary for developing integrated delivery systems that can compete in the highly
competitive managed care environment of the 90s. More recently, some of these integration,
consolidation, and provider entity roll-ups have experienced divestiture and dissolution in
recognition of the failed expectation of capital markets as well as a lack of understanding as
to the difficulty of managing physicians. In either scenario, i.e. consolidation or divestiture,
the valuation of these healthcare provider entities is at the core of each of these transactional
activities.
A. Do You Know What the Trends and Developments Are in the Healthcare
Industry?
Questions to ask!
1. Do you stay informed about the almost daily changes in the industry; thevarious specialties; payment reform and reimbursement trends; the
payer/delivery system mix; costs; emerging healthcare organizations; and
regulatory & enforcement issues related to the health care professional
practice market in general and your practice service area in particular?
Do you have access to a research department that subscribes tohealthcare industry newsletters, journals, and health law & policy
reporters?
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Do you stay in touch with healthcare associations, medicalsocieties, practice brokers, managed care and hospital/system players?
Do you attend conferences, symposiums, workshops, andhealthcare industry seminars?
2. Do you demonstrate requisite skills and consistent effort to make all
appropriate adjustments to the subject practice earnings stream,
professional owner compensation as well as risk adjustments to discount
and capitalization rates?
3. Do you perform regular reviews and reassessments of all reports to insure
compliance with healthcare regulatory and legal constraints and
requirements?
B. Importance of a Professional Valuation
Professional valuations serve a number of important functions for both owners, other
interested or related parties, and potential buyers. For potential transactions, these
include the disclosure of facts, preemption of objections, and establishment of an asking
price. However, one of the most important of these functions may be to avoid potential
legal issues related to Fraud & Abuse laws as described below.
Fraud & Abuse Issues and Endangerment of Charitable Tax Status. A non-profit,
charitable organization (e.g., hospital, foundation) may have its tax exempt status
revoked if it pays more than fair-market value for a medical practice. Internal Revenue
Code (IRC) Section 501(c)(3) tax-exempt organizations must be organized and operated
exclusively for charitable, religious or educational purposes. The tax law contains
prohibitions against private inurement and private benefit for tax-exempt entities. Under
this rule, certain insiders of a tax-exempt entity, including directors/trustees, officers and
certain physicians, may not engage in a non-fair-market-value transaction with the tax-
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exempt entity. If the entity allows such inurement and the private benefit conferred on an
individual is not merely incidental to the exempt activities of the organization, the
organization may have its exempt status revoked by the IRS. On December 22, 1992, aletter from D. McCarty Thornton, Associate General Counsel of OIG of the Department
of Health and Human Services was sent in response to an IRS inquiry regarding kickback
concerns related to an acquisition involving a charitable 501(c)(3) buyer. Mr. Thornton
stated that that any amounts paid to physicians in excess of Fair Market Value of the
practice's hard assets is suspect and could be considered improper inducement for
referrals. It is critical for both the buyer and seller of a medical practice to be assured
that the appraiser is aware of the regulatory issues that govern healthcare business
transactions. Otherwise, both parties may be at risk.
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II. OVERVIEW OF MAJOR HEALTHCARE VALUATION CONCEPTS &
CHALLENGES
A. Healthcare Valuation Context
1. The "IRV" pyramid - The process related to the financial valuation of
professional practices can generally be discussed within the context of two
(2) determinants: (See Exhibit I)
a. "I" = The determination of the appropriate
Income/Earnings/Benefit Stream for the subject practice.
b. "R" = The development and selection of the appropriate risk
adjusted discount rate/cap rate/multiple to apply to the income
stream selected.
2. Therefore, items that are related to each determinant, such as the rapidlychanging reimbursement and regulatory environment, are important to the
appraisal process.
B. Basic Healthcare Valuation Tenets
1. The importance to the practice valuation process of a thorough knowledgeof both the current status of the healthcare industry and practice
marketplace, and the future trends of each is illustrated by the following
basic tenets of practice valuation:
a. Value is forward looking.
b. All value is the expectation of future benefit.
c. The best indicator of future performance is usually the
performance of the immediate past.
d. Historical accounting and other data are useful primarily as a
road map to the future.
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Exhibit I
I
R V
Income/Earnings/Benefit Stream as defined by appraiser & appropriate to
Risk Adjusted Discount Rate/Cap Rate/Multiple risk adjusted and applica
income stream
V A L U E
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2. In light of these basic valuation tenets, the historical performance of asubject practice under the traditional provider delivery system may not be
a valid indicator of its future performance within the context of areimbursement and regulatory environment driven by cost containment,
managed care, and capitation.
C. Reliance on Historical Data
1. Traditional professional practice valuation methodologies have relied
upon the analysis of historical accounting and other data as predictive of
future performance and value. The current turbulent status of the
healthcare industry has introduced intravening events and circumstances
that may have a dramatic effect on the revenue or benefit stream of the
subject practice, i.e. the "road map of historical performance" becomes
less predictive of future performance. An example of events that may
change the prediction of future performance is set forth on Exhibit II.
2. The Total Net Revenues/Practitioner Benefit Stream of the subject
practice, as derived from historical data, must be adjusted to reflect the
most accurate and appropriate information available on the "as of date" to
arrive at an estimate of the "normalized earnings" for the practice. These
adjustments might include:
a. Actual or expected increase/decrease(s) in fees and reimbursementfor services by regulation or competitive market pressures.
b. Projected increase/decrease(s) in practice operating expenses &non-provider compensation related costs based on new practice
operating parameters and market realities.
3. Expectations of the future stability and growth of revenue streams andearnings are difficult to predict and sustain within the context of a chaotic
healthcare industry and practice market place.
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EXHIBIT II
RELIANCE ON HISTORICAL
Q: HOW USEFUL IS PAST IN DETER
AS OF DATEPAST
(5) (4) (3) (2) (1) (1) (2)
Relatively stable Regulatory and
Reimbursement Environment
Traditional fee for service Provider Delivery System
Price to Earnings
Reimbursementincreased for
Primary CareProviders(PCP)
Managed capanel shuts practice -takes patien
PCPs seefewer
patients wihigher Grow/ capitatio
Reimbursementslashed forspecialists
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D. Value as "Incremental Benefit" (See Exhibit III)
1. The economic "Principle of Substitution" states that the cost of an equallydesirable substitute, or one of equivalent utility, tends to set the ceiling of
value, i.e. it is the maximum that a knowledgeable buyer would be willing
to pay for a given asset or property. As applied to the professional
practice appraisal process, this concept is embodied and exemplified in
the "discounted future benefits" method that recognizes that the Fair
Market Value of a professional practice is the aggregate present value of
the total of all future benefits from the subject practice, in excess of the
level of benefits that may be projected to accrue from a hypothetical start-
up practice of the same specialty, setting, format, and location
("Incremental Benefit"). The challenge for the professional practice
appraiser is to arrive at a determination of the present value of this
"Incremental Benefit" within the context of an industry undergoing a "sea-
change" of massively shifting markets, cost structures, and provider
expectations.
2. Determination of hypothetical start-up scenario has become more
complex.
a. The appraiser's determination of the level of benefits derived froma "blended alternative scenario" (a concept which incorporates
the estimated net benefits from a hypothetical start-up of a practice
of the same specialty, setting, format and location, and the
alternative compensation available to the practitioner in the
physician manpower marketplace) must rely on historical data
which is subject to the vagaries of industry changes discussed
above.
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b. The "equally desirable substitute" for professional practitionersthat is required by the "principle of substitution" is more difficultto hypothecate or project at a time when historical trends and
assumptions are often no longer deemed valid by prospective
purchasers.
3. Hypothetical Start-up Earnings are subject to similar uncertainties.
a. It is difficult to gauge the depth of the Professional Practice
Marketplace's perception that the probability of success for
practice start-ups has been diminished by reimbursement and
regulatory pressures.
b. Data related to the costs and earnings of practice start-ups is scarce
and problematic at best.
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EXHIBIT III
VALUE AS INCREMENTAL BENEFIT
INCREMENTAL BENEFIT
(1) (2) (3) (4) (5)
HYPOTHETCAL
STARTUP
THE TOTAL INCREMEBE SAID TO REPRESENOBTAINING AN EQUALSUBSTITUTE TO THE EPRACTICE, i.e. REPLICSTARTUP.
ESTABLISHED, ONGOINGSUBJECT PRACTICE
NUMBER OF YEARS REQUIRED TO REPLICATEESTABLISHED PRACTICE FROM STARTUP
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E. Scope & Nature of Valuation Engagements are Changing - Aspects to
Consider
1. The consolidation and integration of practices have resulted in a largernumber of FTE MDs & larger revenue size of new practice entities.
a. Valuation engagements for a specified minority interest owned by
a provider in larger practice entities can be more complex.
b. Larger practice entities are often multi-specialty with a more
complicated income distribution plan, requiring a diversity of data
for compensation, costs, performance, etc.
c. Larger practice entities limit the universe of potential buyers to
those parties who can handle larger transactions. This places a
great impact on the conceptually favored "market approach"
methodology in that it limits the number of transaction data.
d. IPAs, PHOs, GPWWs, MSOs, and other Emerging Healthcare
Organizations (EHOs) result in unique new practice entities with
altered, scattered asset bases that must be identified, disaggregated
and analyzed.
2. The selection & definition of an appropriate Standard of Value is
problematic with changes in the professional practice market place.
a. Fair Market Value (FMV) presumes a "universe of potentialbuyers" in an open market. Regulatory edicts, such as the
Thornton letter, discourage certain classes of buyers and types of
transactions.
b. Changing reimbursement patterns, payer mixes, and provideralliances make the market for medical practices harder to define &
hypothecate.
c. Market changes due to regulatory and reimbursement demands
may reduce the universe of potential purchasers into a specific
class of potential purchasers. This may change the standard of
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value sought to "acquisition value" vs. Fair Market Value.
3. Government Regulatory Scrutiny & fraud and abuse law prohibitions may
dictate the premise and Standard of Value and, therefore, the methodologyemployed, as well as determine the "permissible assets" for acquisition.
a. Thornton's letter has made suspect any estimates of "goodwill,"
"intangibles," & "future projections."
b. The "premise of value" debate; i.e., "Value in use" (an ongoing
enterprise) vs. "Value in exchange" (liquidation - forced or
orderly) is complicated if the appraiser cannot consider or project
future revenues.
c. Even if the tangible assets of the subject practice are the onlyassets considered, the issue of "Book Value" vs. "Adjusted Book"
also arises. The appraiser ordinarily determines adjustments to
Book Value by first determining the Fair Market Value of the
underlying component assets. Fair Market Value may not be
appropriate as a standard of value under some regulatory
conditions.
d. In response to the "Thornton letter", hospital purchasers are nowoften employing Machinery & Equipment appraisers to value
"hard" or "tangible" practice assets only. Most often they employ
a standard of value called "Fair Market Value in-use-in-place",
rather than liquidation value. It should be noted that "Fair Market
Value in-use-in-place" also relies, in part, on the continuity of a
future earnings stream to support the feasibility of purchase and
maintenance of the underlying tangible assets. There seems to be
an apparent contradiction with the use of this approach to avoid
placing "value" on intangibles.
F. The Range of Services For Healthcare Valuation Reports
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Different types of healthcare organizations and circumstances require valuation
related calculations and valuation reports for a wide range of needs. These needstranslate into an expanded range of services and corresponding reports for
valuators including the following types.
Desktop Analysis & Review: Provides valuation related calculations.No formal correlation, synthesis, conclusion, or certified opinion of value is
provided. Report should provide adequate spreadsheets and notes to support
each of the valuation methods utilized. Report states a range of value
estimates ONLY.
Oral Reports: Requires the same analysis and valuation work-up aseither a "desktop analysis & review" or a "basic narrative valuation report,"
but provides either a range of value estimates or opinion orally, to be followed
by formal letter.
Letter Reports: Requires the same analysis and valuation work-up as a"basic narrative valuation report" but is reported with a letter format with
attached appendices of spreadsheets and data.
Basic Narrative Report: Formal narrative report with table of contentsand attached appendices.
Comprehensive Narrative Report: Basic report plus additional marketanalysis, e.g., utilization demand of practice's services; MD/ population ratios;
incursion of managed care.
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This presentation will briefly touch upon some of the industry background issues and how they
apply to major healthcare valuation concepts and challenges.
III. INDUSTRY BACKGROUND ISSUES
A. The Shifting Universe of Healthcare Delivery (see Exhibit IV)
1. Hospital Centric to Covered Life Centric
2. Market Evolution factors driving move to very large purchasers and verylarge provider networks. (See Exhibit V)
3. Markets have evolved through several stages toward greater consolidation.As markets evolve and enrollment in managed care plans increases, HMO
revenues per member per month decrease along with medical and other
costs.
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EXHIBIT IV
The Shifting Universe of Healthcare Deliv
Hospital
Prevention PrimaryCare
Specialist
Hospital
Access
Mechanism
Wellness
Covered L
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EXHIBIT V
Market Evolution
Economies of ScaleFORCES: Negotiating Power Competitive Pressures
STAGES:IndependentProviders &
Ownership
LooseModels of
Affiliation
TighterLinkages and
Consolidation
M
C
RESULTS:Heightened
Accountability For
Cost and Outcomes
Very Provid
Purch
Integrated Systems
Development
I II III I
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B. Trends in Physician Supply, Workplace and Specialization
1. Trends in Physician Supply - Total MD/Population Ratios have increasedover a thirty (30) year span with a projected increase continuing
throughout the 21st century. The American Medical Association
estimated the ratio of total doctors in patient care per 100,000 population
rose from 132 in 1965 to 226 in 1996, representing an increase of 71.2%
in just over 30 years.1 (See Exhibit VI) With the rapid increase in MD
supply, the patient base per MD is declining, resulting in increased
competition. In concept, this might make it more attractive to acquire an
existing practice that already has a patient base. However, this concept is
challenged by the issue as to whether the patients still "adhere" to
practices or to payers (e.g. insurance plans).
U.S. Physician/Population Ratios2:
Year Total Physician Population Physician/Population Ratio
1950 219,997 1:703
1960 260,484 1:703
1970 334,028 1:623
1980 467,679 1:494
1990 615,421 1:410
1996 737,764 1:360
2022 860,000 1:3393
1 Physician Characteristics and Distribution in the U.S. 1997/98 ed. American Medical Association, 1997, p. 34.2 Ibid.3 Seeking a balanced physician workforce for the 21st century. JAMA, V. 272 (9), Sept. 7, 1994, p. 680-687 (seefig. 2).
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EXHIBIT VI4
2. The Proliferation of Medical Groups and Employed Physicians - In the
1960s and 1970s, the physician enterprise was characterized by solo-
practitioners. In 1965, 11% of physicians practiced in groups with other
physicians. By 1995 this figure had risen to 34%.5 As the financing of
healthcare changed, the organization of physicians has also changed. The
proportion of employed physicians has risen from 26.2% to 39% between
1991 and 1997.6 The change can be attributed primarily to hospitals
purchasing medical practices in an effort to create integrated delivery
systems and the emergence of PPMCs.
3. Trends in the Specialization of Professional Practices - While the trend of
4 Source: Rovner, Julie, The State of Health Care in America Business & Health Magazine: 19965 Medical Groups in the US: A Survey of practice characteristics. 1996 ed. American Medical Association, p. 45.
6 Physician Marketplace Statistics, 1997/98. AMA, 1991& 1997, p. 8, 109.
0
50
100
150
200
250
300
350
1960 1970 1980 1990 2000 2010 2020
Physicians per100,000
population
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physicians entering medical school since the 1960s has been focused on
specialization, attempts are being made to turn the focus to primary care as
the specialty of choice. With the rise of managed care, the increased roleof the "gatekeeper," and the rapid consolidation of healthcare providers
into integrated delivery systems, a premium in "value" has been placed on
primary care physicians in some markets. Not withstanding this and
government sponsored efforts to effect a change, recent surveys indicate a
majority of medical students still plan to specialize.
Surveys based on 1998 data have surmised that the United States would
need about 17,000 fewer medical specialists, 19,000 fewer surgical
specialists and 29,300 additional primary care physicians (including
obstetrics and gynecology) if everyone in the country was enrolled in an
HMO.7
One could attribute the fact that medical students are still specializing, to
the growing aging population. According to data from the Center for
Health Statistics patients age 65 and over have an Average Length of Stay
(ALOS) for short-stay hospitalizations of 6.3 days compared with 4.3 days
for population under 65 years old. 37 % of all procedures for discharges
from short-stay hospital are for patients 65 years and older. Those over 65
years old are responsible for 65% of all discharges from short-stay
hospitals.8 For some specialties, such as cardiology, the effect is even
greater. The number of office visits to cardiologists is over 10 times
higher for patients age 65 and over9, while discharges from short-stay
7 Physician Resource Planning, 9th Edition, Sachs Group, 1998.8 Lawrence L, Hall MJ. 1997 summary: National Hospital Discharge Survey. Advanced data from vital and healthstatistics; no. 308. Hyattsville, Maryland: National Center for Health Statistics. 1999, p. 3, 5, 12.9 Schappert SM. Ambulatory care visits to physician offices, hospital outpatient departments, and emergencydepartments: United States, 1996. National Center for Health Statistics. Vital Health Stat 13(134). 1998, p. 9.
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hospital for heart diseases are three times higher.10 Due to the patient age
mix, there seems to be an increased need for specialists which may
suggest a balancing effect on supply and demand.
Overall, the trend of practice continues to move toward specialization and
away from primary care. While it is expected that patient care demand
will continue to grow, it is not projected to be enough to absorb an
expected oversupply of specialists, according to the Council of Graduate
Medical Education (COGME). While recent efforts to redirect medical
students to primary care are significant, long term results are still
inconclusive.
In 1996, 40% of all physicians were primary care physicians only slightly
less than the 41% which were in primary care in 1970. However, within
primary care there was a trend toward subspecialization and away from
general practice. Of the primary care specialties as of December 31, 1995,
Internal Medicine is the largest at 41%, with Family Practice second at
21%, followed by Pediatrics (18.5%), Obstetrics/Gynecology (13.4%),
and General Practice (6%).11 (See Exhibit VII) These specialties have
become more attractive and such practices are often highly sought after as
patient care "gatekeepers" in managed care oriented delivery systems.
Even with a recent trend towards "right-sizing," i.e., the reduction in
specialists allowed in managed care networks or panels, the trend toward
specialization continues, as insurance plans provide Point of Service
(POS) options which allow patients the option of directly selecting
specialists for a higher copay. This approach, often called the Open
10 Benson v and Marano MA. Current estimates from the National Health Interview Survey, 1995. National HealthInterview Survey, 1995. National Center for Health Statistics. Vital Health Stat 10(199). 1998.11 Physician Characteristics and Distribution in the U.S., 1997/98 ed. American Medical Association, 1997, p. 279-280.
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Access Specialty Based Model, becomes particularly attractive for HMO
plans that develop disease management carve-outs and integrated
specialty care aimed at a specific disease with at risk managed carecontracts.
EXHIBIT VII
C. Changes in the Professional Practice Competitive Environment
1. The emergence of competing providers from Allied Health Professions,
physician extenders and para-professionals, as "lower cost providers"
has increased competitive pressures on physician practices.
a. Competing Providers - Allied Health Professions
(1) Psychiatrists - versus -Psychologists - versus -Licensed
41%
21 %
19%
6%13 %
InternalMedicine
Family Practice
Pediatrics
OB/GYN
General
Practice
Distribution of Primary Care Doctors by Specialty
Source: 1997-98 Physician Characteristics and Distribution in the US. AMA, 1997.
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Psycho-therapists
(2) Ophthalmologists - versus - Optometrists -versus - Opticians
(3) Orthopedists - versus - Osteopaths - versus - Chiropractorsb. Physician Extenders or Para-professionals can either compete or
add practice revenues. Para-professional have the effect of also
increasing practice productivity and revenue.
(1) Physician's Assistants (PA) - The Association of Physician
Assistant Programs reported 2.3 job offers for each PA
graduate in 1997.12 The ratio of Physician Assistants per
100,000 is 11.7. The U.S. Labor Department predicts that
the number of PA positions will grow 47% by 2006.13
(2) Nurse Practitioners (NP) - According to the Nurse
Practitioner Support Service, the number of NPs is 33.6 per
100,000 population.
(3) Nurse Midwives
(4) Certified Registered Nurse Anesthetists (CRNAs)
2. Managed care plans have challenged the traditional providers hold onpatient loyalty and referral patterns. As a result of the demand for cost
containment, there has been a rapid growth in the number of patients
covered by managed care. (See Exhibit VIII) Health Maintenance
Organizations (HMOs) and Preferred Provider Organizations (PPOs),
have sought to combine the role of the insurance company, utilization
review organization, and medical services provider in order to offer
prepaid medical plans to subscribers thereby forcing cost containment by
integrating operational and financial functions.
12 Perceptions of Marketplace Demand: Results of National Survey of 97 Physician Assistant Graduates.Perspectives on Physician Assistant Education, Vol. 9, no. 14, Autumn 98, p. 192-196.13 U.S. Department of Labor. Monthly Labor Review, Vol. 120, no. 11, Nov. 1997, p. 65.
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a. The growing acceptance of managed care in the healthcaredelivery system is exhibited by ongoing enrollment trends. In
1996, 160 million people were estimated to be enrolled in amanaged care plan, up from 112 million in 1995.14 The number of
Americans insured by HMOs grew nearly 15 percent from 57.2
million to 65.6 million in this same time period with HMO
enrollment up almost another 13 percent to 73.8 million from 1997
to 1998.15 Such enrollment growth should continue as public and
private payors transfer more covered lives into managed care
programs.
b. Employers of all sizes and in all regions of the country saw
increases in managed care enrollment.
(1) HMO enrollment among large employers nationwide rosefrom 72% of all eligible employees in 1997 to 87% in
1998, again exceeding indemnity plan enrollment.16
Dramatic growth rates are occurring among small business
employers.
14 The Guide to the Managed Care Industry. HCIA, 1998, p. xi.15 The Guide to the Managed Care Industry. HCIA, 1999, p. XV.16 InterStudy Competitive Edge Part II: HMO Industry Report. InterStudy Publications, Jan. 1, 1997, p. xiv, 2, 34 and Jan. 1, 1998, p. 6.
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Exhibit VIII
c. Corporate Employer Alliances and Healthcare Provider Networks are
being formed and driven by corporate healthcare buyers who want
one-stop healthcare shopping with cost containment and quality
outcome measurement.
d. Provider Sponsored Organizations (PSOs). PSOs have been
developed in order to allow providers to accept financial risk in
providing services to Medicare and Medicaid enrollees. The 1998U.S. fiscal budget defined PSOs as majority provider owned
entities providing all medical care for 1500 or more Medicare
enrollees in urban areas and 500 in rural. PSOs are licensed by the
states and will bear the full financial risk in contracting with
Medicare. Payment will be on a capitated basis, with per member
Managed Care Continues to Edge out Indemnity CoveragePercent of Employees Enrolled by Region and Plan Type
Source: The managed-care juggernaut: Explosive growth nationwide. Medical Economics, April 15, 1996.
00.05
0.1
0.15
0.2
0.250.3
0.35
0.40.45
West
Midwest
South
Northeast
Nationwide
Indemnity
POS
PPOsHMOs
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per month (PMPM), payments. State solvency standards vary for
PSOs. Federal solvency standards of $1.5 million, with half in
cash or cash equivalents.
e. The Rise and Fall of the Gatekeeper System.
The Gatekeeper System, where patients may not consult specialists
without first obtaining a referral from a primary care physician, is
another cost containment measure impacting practice today. This
system elevated the value of primary care physician practices
within markets dominated by the gatekeeper system.
In the last few years, health plan designs are offering more
consumer choices, especially the open access, specialty based
model which does not rely on PCPs as gatekeepers but uses other
medical management tools to allow patients to see the most
appropriate provider for their condition.
Patient protection legislation including limited direct access to
specialists continues to be debated by Congress as the result of
public outcry against the restrictions of managed care including the
gatekeeper system. A bipartisan bill was introduced in October of
1999 that would ensure that decisions on medical necessity would
be made by physicians alone, that enrollees have the right to select
a point of service plan option, direct access to OB/GYNs and
pediatricians, better disclosure of information about health plans, a
prudent layperson standard for emergency coverage, the
prohibition of gag clauses in physician contracts, and external
appeals of health plan decisions. The rights of patients to sue their
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HMOs has also been the subject of recent legislative debate.
In addition to public scrutiny of their medical managementtechniques, HMOs are facing increasing financial pressures as
competition and the negotiating power of purchasers keep
premium growth below rises in medical and administrative costs.
HMO profitability fell between 1994 and 1997 with median HMO
operating losses of 3.5% in 1997 and 1998.17
Even the largest HMOs have not been immune to these public and
financial pressures. Aetna, the largest U.S. healthcare benefits
company, lost two thirds of its stock price between 1997 and the
spring of 1999. This was despite growth in revenues (largely
through acquisitions, notably Prudential Healthcare in July 1999)
and earnings with approximately $1 billion in earnings in 1999.
Resulting shareholder pressure has led to the unexpected
resignation of Aetnas chairman and CEO, Richard Huber, and the
decision to split the company into two independent publicly traded
companies and to sell off its international assets as part of its
reexamination of all its business strategies including its all-
products policy requiring physicians to contract for all of Aetnas
products if they wish to provide any of them.
17 The InterStudy Competitive Edge: HMO Industry Report 9.2. InterStudy, 1999, p. xi.
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D. Reimbursement Issues and the Transition to Capitation
Physician compensation levels have come under increasing pressure with theintroduction of managed care and governmental cost control efforts. However,
despite these pressures, the average annual percentage change in median net
income after expenses before taxes, for nonfederal physicians, 1986-1996 was
5.2%.18
(See Exhibit IX)
EXHIBIT IX
Physician Compensation19
Groups Hospital/Systems Managed Care
Full-Time $187,827 $170,258 $156,954
Part-Time $64,660 $105,966 $108,123
Have contract 50% 62% 42%
Contract/years 2.3 1.7 1.9
Severance/months 10 8 11
Physician Income by Size of Practice20
# of Practice MDs: Solo Two Three 4-8 Over 8
Median Net Income $150,000 $188,000 $200,000 $250,000 $230,000
The following chart (Exhibit X) illustrated trends in physician compensation by specialty
over the last several years.
18 Physician Marketplace Statistics 1997/98. American Medical Association, 1998, p. 85.19 A Report of Surveys of Managed Care Organizations, Hospitals/Systems and Group Practices. The Instituteof Physician-Management Relations, Witt/Kieffer, Ford, Hadelman & Lloyd, 1996.20 Physician Marketplace Statistics 1997/98. American Medical Association, 1998, p. 87.
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Exhibit X
$0
$25,000
$50,000
$75,000
$100,000
$125,000
$150,000
$175,000
$200,000
$225,000
$250,000
$275,000
1994 1995 1996 1997 1998 1999
Anesthesiology
Cardiology
Emergency Medicine
Family Practice
General Surgery
Hospitalists
Internal Medicine
Neurology
OB/GYN
Oncology
Pathology
Pediatrics
Psychiatry
Radiology
Urology
Physician Compensation Trends 1994-1999
Source: Modern Healthcares annual report on physician compensation, 1994-1999.
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1. Healthcare Industry Symptoms Drive Payment Reform
a. The idea of payment reform has been spurred by the perceivedfailure of healthcare industry cost containment. The perceptionhas been driven by:
(1) Lack of Accountability for Cost
(2) Supply Driven Inelastic Demand
(3) Excess Capacity of Providers and Specialty Imbalance
(4) Cost-Plus Reimbursement
(5) Unsustainable High Profit Margins of Industry andProfession
b. The transition from the passage of Title XVIII of Social Security
Act 1965 until the passage of the Omnibus Budget Reconciliation
Act (OBRA) of 1989 included:
(1) OBRA '85 directed the development of RBRVS
(Hsiao/Harvard Studies).
(2) OBRA '86 reduced payments for cataract surgery &anesthesiology - setting out the concept of "inherent
reasonableness" for the first time.
(3) OBRA '87 provided payment reductions for 12 additionalgroups of "over-valued" procedures.
(4) OBRA '89 established volume performance rates, replacedCPR with a fee schedule based on relative values (RV), and
replaced the maximum actual allowable charge (MAAC)
restriction on non-participating MDs with a new limiting
charge. States shrink caps.
(5) OBRA '90 [Public law 101-508] made revisions to OBRA
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'89 RVs, asserted "budget neutrality", and set transition
rules.
(6) Final rules & schedules were published by HCFA in theU.S. Federal Register 11/25/91 which took effect 1/1/92.
(7) OBRA 93 rewarded primary care, exempted "clinicswithout walls," further adjusted reimbursement to
specialists and surgeons.
c. The implementation of the Resource Based Relative Value Scales
(RBRBS), completed from 1991 to 1996, as the new Medicare fee
schedule has played a significant part in changing reimbursement
patterns and practice revenues. RBRVS assigns medical
procedures with Relative Value Units (RVUs) based on the
necessary resources used to perform a medical service: i.e.
overhead, malpractice insurance costs, and physicians' work.
Payment levels are based on the RVUs for a procedure,
geographically adjusted, and multiplied by a Conversion Factor.
In assigning the relative values to procedures and in making yearly
updates to these levels, the government has deliberately shifted
payment levels to primary care specialties in order to redress what
they believe are historic inequalities perceived to cause medical
students to over specialize and thereby raise healthcare costs.
These adjustments in reimbursement levels have and are forecast
to have significant impacts for many specialties as is illustrated in
Exhibit XI.
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Exhibit XI
-40%-35%-30%
-25%-20%-15%-10%
-5%0%5%
10%15%
20%25%30%35%40%45%50%
FamilyPractice
GeneralPractice
InternalMedicine
Otolaryngology
Neurology
Pulmonary
Dermatology
Nephrology
Urology
OrthopedicSurgery
Pathology
Gastroenterology
Cardiology
GeneralSurgery
Radiology
PlasticSurgery
Neurosurgery
Ophthalmology
Anesthesiology
ThoracicSurgery
Pe rcent Change in Medicare P ayments 1991-2002
Sources: Created through the composite analysis of various reports from the Physician Payment Review Commission, Physicians Payment Update, and HCF
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2. Will RBRVS be Abandoned?
a. Healthcare payment reform is gaining momentum, having shiftedfocus from the federal to the state level. With continued costcontainment pressure, RBRVS is likely to be replaced by capitated
plans, at least in those areas where excess provider capacity has
been squeezed out of the system.
b. Diverting from a fee for service to a capitated basis may have amore significant impact on practice value than the implementation
of RBRVS, due to the shifting of "risk" from payer to provider.
c. Notwithstanding the above, RBRVS has become the standard forthe negotiation of most commercial managed care contracts
supplanting the utilization of St. Anthonys Relative Values for
Physicians (fka McGraw-Hill) which has historically been
preferential to specialists and surgeons.
3. The transition from a fee-for-service form of reimbursement to capitation
will cause healthcare providers to alter their ways of delivering care.
a. The transition to capitation may offer positives to providers.
(1) Provides for immediate access to reimbursement(2) Gives freedom from insurance utilization controls and pre-
authorization requirements
(3) Is considered attractive to payers(4) Potentially increases information sharing
b. Capitation also has several restrictions that should be considered in
the valuation process.
(1) Fixed reimbursement requires significant and consistentutilization management and the tracking of referrals with
their incurred but not reported (IBNR) liabilities.
(2) Quality of care may be compromised in certain casesbecause of inadequate treatment or extended waiting times
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(3) Establishing parameters and administrative guidelines canbe complicated
(4) Adverse selection in small populations can inhibit costcontainment
4. Government Reimbursements Change to Prospective Payments Systems
Medicare and Medicaid originally paid for hospital services using a cost
plus reimbursement basis, where hospitals were paid for all of their costs
and more. The rising costs associated with this system led to the
introduction by the federal government of a prospective pricing system
for hospital payment, where hospitals are reimbursed an average, qualified
amount for each patient treated with the same type of diagnosis specified
by Diagnostic Related Group (DRG). The government is currently
developing prospective pricing systems for reimbursement for ambulatory
surgery centers, hospital outpatient services, home health care, skilled
nursing facilities, and rehabilitation facilities. There are also plans for a
prospective pricing system for long-term hospital care. Since the
government is the single largest payor for healthcare services, these
changes exert enormous pressure on providers to reduce costs.
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IV. THE RISE OF EMERGING HEALTHCARE ORGANIZATIONS (EHOS)
In response to the market forces described above, providers are consolidating and
integrating into new organizational forms, called Emerging Healthcare Organizations
or EHOs, to attempt to compete more effectively. The business objective in healthcare
now is control over covered lives. Emerging Healthcare Organizations are generally
formed to pursue this goal.
An emerging healthcare organization is an organizational form
consisting of hospital(s), physician(s), and/or health plan(s) that have
consolidated, merged, integrated or affiliated in response to managed
care and integration forces in their market.21
The critical element to this broad definition is the reason for an EHOs existence. Market
forces, primarily demands for lower prices and/or improved outcomes, catalyze EHO
development and operations.
EHOs are vehicles for physician integration. In a cost-sensitive managed care
environment or a more progressive outcome-focused one, it is critical for payors and
others who bear risk for health services to have strong relationships with physicians. The
rationale is simple: physicians direct care, thereby giving them considerable control over
healthcare expenditures and medical outcomes.
Physician integration models such as EHOs combine groups of providers to compete in
the market as the "highest quality, lowest-cost provider" of healthcare services.
However, along with the growth and penetration of managed care, the evolution of these
systems, organizations, and networks challenges the traditional healthcare delivery
21 Capital Survey of Emerging Healthcare Organizations. Second Annual Report 1996, Integrated Healthcare
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systems, especially the traditional, independent private practice of medicine. As
physicians integrate to seek leverage in the marketplace they lose varying degrees of their
practice autonomy. The relationship between autonomy and leverage is illustrated inExhibit XII.
Report, Medical Group Management Association, and Ziegler Securities, 1996, p. 1.
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EXHIBIT XII
Autonomy/Leverage Diagram
L E V E R A G E
SOLO PRACTITIONER
INDEPENDENT PRACTICE ASSOCIATION (IPA)
GROUP PRACTICE WITHOUT WALLS
MANAGEMENT SERVICES ORGANIZ
A
U
T
O
N
O
M
Y
PHYSICIAN/HOSPITAL ORGANIZATION (PHO)
AUTONOMY /PRACTICEINDEPENDENCE
HOSPITAL
DEPENDENT
PRACTICE
FLEXIBILITY OPERATING
EFFICIENCIES
(SHORT TERM)
MANAGED CARE ATTRACTIVENESS
SECURE REFERRAL SOURCES
OPERATING EFFICIENCIES (LONG TERM)
PRACTICE STABILITY
MANAGEMENT SERVICES BUREAU (MSB)
FULLY INTEGRATED
MEDICAL GROUP (FIMG)
INTEGRATED DSYSTEM (ID
FINANCIAL REWARDS
START-UP CAPITAL/FINANCIAL COM
FINANCIAL/OPERATING RISK
COMPLEXITY (LEGAL, OPERATIONA
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A. Types of EHOs
1. Classification
EHOs take numerous forms to fill may functions in todays marketplace. To
simplify the complex situation, this course focuses on six major EHOs:
1. Independent Practice Association (IPA)
2. Physician Hospital Organization (PHO)
3. Physician Practice Management Company (PPMC)
4. Management Services Organization (MSO)
5. Fully Integrated Medical Group (FIMG)
6. Integrated Delivery Systems (IDS)
In addition to these models, a section on Group Practices Without Walls
(GPWWs), a less prevalent model, but one which is important in the history of
EHOs, is included.
2. Type and Degree of Integration (See Exhibit XIII)
By definition, EHOs are integrated businesses. However, EHOs level of
integration varies in degree and in forms, whether horizontal or vertical.
Horizontal integration is the acquisition and consolidation of like organizations
or business ventures under a single corporate management, in order to producesynergy, reduce redundancies and duplication of efforts or products, and achieve
economies of scale while increasing market share.22 When hospitals join
together and create hospital systems or when physicians join forces to form
22 Peter Boland. The Capitation Sourcebook. Boland Healthcare, 1996, p. 618.
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organizations that primarily offer physician services, horizontal integration is at
work.
Vertical integration involves to joining of organizations that are fundamentally
different in their product and/or services offerings. It is the aggregation of
dissimilar but related business units, companies, or organizations under a single
ownership or management in order to provide a full range of related products and
services.23 The evolution of many healthcare markets is being driven by a vision
for fully-integrated organizations.
Exhibit XIII
23 Ibid, p. 629.
Evolution and Continuum of Physician Integration
Shared Economic RiskLEAST MOST
MOST
LEAST
Solo
Practice
IndependentPractice
Association
Group Practice
Without Walls
Open PHO
Closed PHO
Comprehensive
MSO
FoundationModel
Equity
Model
Staff/EmployedModel
Management
Service
Bureau
Fully Integrated
Group Practice
IndividualDecisionMaking
MSO
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3. A Framework for Understanding EHOs.
A framework for the emerging enterprises in the business of healthcare is shownin Exhibit XIV below. Its rows classify each EHO by its function and level of
integration (least integrated at the top) and the columns denote integration type
(horizontal versus vertical). In less technical terms, it is a two by three matrix
where the short axis represents the type of integration and the long axis represents
the type of business operations.
Exhibit XIV
Each of the three levels can be identified according to their business strategy:
PHO
MSO
IDS
IPA
PPMC
Multi-Specialty
Group Practice
WHYWHAT
Horizontal Vertical
Maintain Status Quo
Cost Containment
Change Care Process
Managed Care
contracting
Operations / Economies
of Scale
Population-based healthmanagement
EHO Models
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I: Resistors. Organizations designed to maintain the status quo, fend off managed
care, or slowly learn how to successfully operate in a managed care environment.
IPAs and PHOs
II: Cost Containers. Organizations that are capable of controlling healthcare
costs through economies of scale. Their ability to contract effectively with
managed care organizations and systematically reduce utilization of services is
limited, however.
PPMCs and MSOs
III: True Integrators. These are organizations that are so financially integrated
through risk contracting or ownership, true integration of care processes is
possible. There are very few true integrators operating in the United States, but
many EHOs see themselves as evolving toward true integration.
FIMGs and IDSs
4. Independent Practice Associations (IPAs)
The acronym IPA stands for Individual Practice Association or Independent Practice
Association. It is a legal entity of independent physicians that contracts with health
insurance companies to provide medical services. IPAs are generally not-for-profit,
although it is not a requirement. Individual physicians operate under their own tax IDs,
Medicare provider numbers, etc. and generally do not share administrative overhead or
centralized systems such as billing and claims processing information systems. Although
some IPAs include investment by hospitals, this section focuses on the horizontally-
integrated IPA which excludes hospitals and other non-physician-controlled businesses.
Refer to Exhibit XV for an illustration of the organizational form of an IPA.
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Over 1200 IPAs have been identified by the American Hospital Association, but because
they are forming so quickly, the actual number may be twice this many. In 1997, 50
percent of physicians participated in managed care contracts via IPAs, and for theaverage physician these contracts represent about 20 percent of their revenues.
Exhibit XV
5. Physician Practice Management Companies (PPMCs)
a. Definition
Although Physician Practice Management Companies have been classified as
simply publicly traded MSOs, there is a more refined definition. First, to be
classified as a PPMC, an organization must be physician-dominated. PPMCs are
INDEPENDENT PRACTICE ASSOCIATION (IPA)
Physician Practice
IPA
Billing and Collection
UM/QA
Usually, Risk-sharing or
Capitation Accounts
IPA-ContractedPayor
Non-IPA ContractedPayor
Provider Agreement
$ (multiple reimbursement mechanism)
Provider Agreement
May be fee-
for-service or
capitation
$
Ownership
$
(usually
capitation)
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management firms that specialize in the management of large group practices or
IPAs through ownership, management agreement, or both. PPMCs generally own
the physician practices with which they affiliate via subsidiaries. In the last fiveyears, PPMCs have acquired increasing numbers of physician practices.
Physician Practice Management Companies offer access to the capital markets
that physicians have not historically had. With capital, physicians in PPMCs have
been able to build surgery centers, expand service lines, and bolster contracting
leverage with managed care organizations, hospitals, and health systems.
b. PPMC Business Performance
The publicly traded industry has undergone large swings in its market
capitalization. As discussed earlier, several of the major publicly traded PPMCs
have gone bankrupt or decided to leave the practice management business. Poor
financial management including over aggressive acquisitions have contributed to
this recent industry shakedown. The number of public PPMCs could continue to
fall in the short term as some of the remaining companies restructure or close
their practice management operations. Generally multispecialty PPMCs have
performed far worse that those which focus on a single specialty or condition.
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Exhibit XVI
6. Physician Hospital Organizations (PHOs)
A Physician Hospital Organization (PHO) unites a hospital or group of hospitals
with a physician organization through a contractual relationship. The PHO is
usually owned by the physicians and/or hospital and, in many cases, is a non-
profit organization. In Exhibit XVII, individual physicians own shares of a
physician organization that enters a joint venture with a hospital called a PHO.
Physician Practice Management Company (PPMC)
Equity Model
The PhyCor Model
MOST COMMONPPMC
Local Subsidiary of PPMC
(50/50 Governance)
(Not Always Implemented)
Professional
Association/Corporation
MDsAssets
Non-MD Staff Initial 3-5 yr Contract
Long-termAgreement
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Exhibit XVII
7. Management Services Organizations (MSOs) (Exhibit XVIII)
An MSO is a legal entity owned by physicians, hospitals, or lay investors that
provides an array of practice management services. Traditionally, MSOs have
provided a variety of services to both medical practices and hospitals. An MSO
can also be referred to as a PSN, or Physician Services Network; an MSB, or
Management Services Bureau; or a Practice Asset Organization.
In their [most] basic form, MSOs sell practice management services for a
Medical
Group
Medical
Group
Medical
Group
Physician Hospital Organization Hospital
Physician Hospital Organization(PHO)Joint Ownership Structure
Shareholders Shareholders
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monthly fee,24 but the services provided by MSOs encompass a broad range and
include, but are not limited to: operations management, marketing, contract
negotiation, new assets acquisition, personnel management, leasing, providingsupport services to other organizations (i.e., hospitals), physician recruitment,
MIS development, purchasing, and facilities development.25
Exhibit XVIII
8. Group Practices Without Walls (GPWWs) (Exhibit XIX)
A Group Practice Without Walls (GPWW), also called a clinic without walls, is a
24 Perry, Kristie, Would an MSO Make Your Life Easier? Medical Economics, April 10, 1995.25 Goldstein, Douglas, From Physician Bonding to Alliances: Building New Physician-Hospital Relationships,Capital Publications, Inc, 1992, and Peters, Gerald R., Esq., Healthcare Integration: A Legal Manual forConstructing Integrated Organizations. National Health Lawyers Association, 1995.
Management Services Organization (MSO)Joint Venture Hospital Physician-Owned
MSO Payors
Non-owner
Physicians
Owner
PhysiciansHospital
Medical
Services
Ownership
Managem
ent
Services
$
$
Ownership
Management
Services $$
Medica
l
Service
s
ProviderAgreement
ProviderAgreement
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network of physicians who have merged into one legal entity but maintain control
over individual practice sites. A GPWW does not include the participation of
hospitals or other non-physicians. In forming of this type of organization,physicians aggregate their practice assets (tangible and intangible) into one entity,
providing them with contracting leverage with managed care organizations.
GPWWs differ from MSOs in two ways:
1) only physicians may be owners of GPWWs, and2) a GPWW acquires all assets, while an MSO acquires just tangibles.
Exhibit XIX
9. Fully Integrated Medical Groups (FIMGs)
A Fully Integrated Medical Group (FIMG) is a highly integrated medical group
Group Practice Without Walls (GPWW)
Site A Site B Site C Site x
GPWW
Physician Owner
Payors
Provider Agreement
$
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practice organized as a single legal entity. Management is centralized and has
sufficient authority to effectively manage both the medical and business
operations of the group allowing FIMGs to integrate clinical, financial, andoperational aspects of the practice. An income distribution plan aligns the
incentives of the physician and the group. FIMGs are organizations often called
physician equity groups, which can vary in their level of integration from that
of traditional practices to that of FIMGs. The real differentiating factor between
group practices and FIMGs is the level of integration a subjective quality.
Exhibit XX
10.Integrated Delivery Systems (IDS) (Exhibit XXI)
As providers consolidate and Managed Care Organizations seek to contract on a capitated
basis for the provision of all of the care that patients require, hospitals and physicians, as
Fully-Integrated Medical Group (FIMG)
Provider Agreement
$
Payor
Non-Owner
Physicians
Owner
Physicians
Medical Group
Employment
Agreement
$
Compensation
Emplo
yment
Agreement
$
Compensation
Ownership
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the traditional providers of care, are destined to become more and more integrated into
single organizations. Most existing Integrated Delivery Systems (IDS) began when
hospitals acquired or affiliated with physicians through PHOs or MSOs for the purposeof managed care contracting.26 These organizations desire to expand the range of
services they provide has led to their merger, acquisition, or affiliation with other types of
facilities such as long-term care, skilled nursing facilities, and ambulatory surgery centers
as well as with ancillary providers including laboratories and diagnostics.
Exhibit XXI
26 DeMuro, Paul R. Managed care & integrated delivery systems: Strategies for contracting, compensation &reimbursement. Irwin Professional Publishing, 1995, pp. 13-14.
Integrated Delivery System (IDS)
Hospitals
Outside Payor
Physician
Organization
Provider Agreement
$
Provider Agreement
$
Provider Agreement
$
Provider Agreement
$
Provider
Agreements$
$
$
$
Other Providerslabphysical therapyhome healthetc.
HMO
(optional)
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B. Challenges to the Valuation of Emerging Healthcare Organizations (EHOs)
1. Identifying the Relationships Among All Entities (See Exhibit XXII) Ownership of both tangible & intangible assets Identification of structure, governance, control & risk relationships
within entity
2. Tracking the Cash Flows
Value is related to the probability of the continuity of net cash flows The quality and expected duration of the cash flow must be determined Unrecognized liabilities, e.g. IBNR and related matters must be
accounted for
3. The Developing Market
Transactions involving IPAs, MSOs, and other EHOs are currentlybeing seen in the marketplace, and these transactions require
valuations
Both Transactions and Guideline Companies are available forcomparison utilizing market concept valuation approaches
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EXHIBIT XXII
Emerging Healthcare Organizations
Q. What holds the value?A. It depends on the legal and organizational structure
Intangible Assets may include:
Service Contracts with Third Party Payors & MCOs Strength of Agreements with all Providers Management Services Agreements Provider Services Agreements
Capture of the Ancillaries (Lab, Diagnostics, etc.) Other Intangibles
Tangible Assets may include:
Cash and Accounts Receivable Hard Assets: Furniture, Fixtures, & Equipment (FF&E) Real Estate and Buildings Durable Medical Equipment (DME) and Supplies
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V. TRENDS IN HEALTHCARE TRANSACTIONS
A. Physician to physician transactions
1. As managed care penetration increases, physicians are reacting to the
market's signals. According to a 1997 Medical Economics survey of
11,104 practicing physicians, 38% had structurally changed their practices
or planned to do so in 1998.27
Types of physician-physician transactions
include:
a. Recruitment of new associates or partners
b. Medical practice sale by a retiring physician
c. Medical practice expansion through acquisition
d. Establishment of practice satellite location
e. Group practice formation
f. Establishment of a physician organization (PO)
2. While these types of transactions have been frequent in the past, the total
number of physician to physician transactions has been significantly
reduced as a result of integration/consolidation efforts.
B. Physician Practice Management Company (PPMC) transactions
Competing in todays marketplace calls for a rapid growth by physician-led
integrated health care organizations. Three market forces have caused physicians
to financially merge their medical practices: (1) the increased financial benefit
from revenue from owned related health services without violating Stark II, (2)
the ability to negotiate risk and non-risk managed health plan contracts with
sufficient leverage, and (3) the promise of creating a larger economic entity
capable of accessing outside sources of capital on favorable terms.
27 "Doctors on the move". Medical Economics, Vol. 74, No. 24, December 8th 1997, page 145.
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Publicly-traded Physician Practice Management Companies (PPMCs) emerged in
response to physician practices needs for capital, strong management and
managed care expertise in an increasingly competitive healthcare industry. In1997, 34 public PPMCs raised $2 billion28.
Physician practice acquisition has become a corporate deal that is no longer quiet.
As of early 1998, investor-owned PPMCs were buying physician practices at 5-
10 times EBIT29 with a high percentage of the price paid in stock and making
news in the Wall Street Journal. With hospitals and health systems (both for-
profit and non-profit) purchasing medical practices as well, the competition for
quality physician practices was high, and likewise the transaction prices.
1999 has seen the pace of practice acquisitions greatly slowed and in many
markets PPMCs and hospitals are divesting previously acquired practices. The
reasons for these sales are varied but they have in common the failed financial
and strategic performance of acquired practices resulting from overall poor
management. Many of these purchasers underestimated the complexity of
effective practice management.
Before the current downturn in acquisitions, it was estimated that PPMCs
acquired approximately 260 physician practices in 1997.30
Initially, stock prices
and growth of these companies outpaced stock indexes, but recently these
companies have underperformed the market. Despite their recent poor stock
performance as a group, PPMCs offer physicians an innovative mechanism to try
to regain control of the healthcare industry by providing physicians with access to
capital, management, and managed care expertise.
1. The Collapse of Publicly Traded PPMCs
28 Ibid.29 1998 PPMC Yearbook, Sherlock Company, May 1998..30 The 1998 PPMC Yearbook. Sherlock Company, 1998, p.17.
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PPMCs emerged over the past five years as a vehicle of change for physicians.
The companies initially enjoyed strong growth in revenue and earnings duringtheir first few years31. In 1998 Sherlock Co. identified 164 PPMCs, 39 of which
were then publicly traded.32 Thirty-four public PPMCs (as of April 14, 1998)
were affiliated with 5% of the nations active physicians.33 To support their
growth, PPMCs offered lucrative buy-out deals to physicians, especially
compared to the hospital buy-out offers and physician-physician deals. The
PPMC industry attempts to aggregate medical practices in order to build market
clout and boost their stock performance.
However, in the last year, PPMCs have suffered from various management and
financial problems and in the nine months ending September 1998, the market
capitalization for publicly traded PPMCs fell 58%. In the first half of 1999,
PPMC stocks have underperformed the market, falling over 30% compared with
the 8.8% growth of the S&P 500.34 Since last September, several of the largest
PPMCs have declared bankruptcy or have decided to exit the practice
management business. Some of the larger companies involved are noted below.
In July of 1998, FPA Medical Management declared bankruptcy, theresult of poor management, financial and otherwise, and over aggressive
acquisitions. Its stock price fell to $.18 per share from $18 per share four
months earlier. California physicians were shorted $60 million in payments
and physicians nationwide may have lost $200 million in payments.35
PhyMatrix announced in October of 1998 that it would divest its group31 ONeil, B, Manderfeld, T. Physician Practice Management: Searching for Value. Piper Jaffray, August 1997.32 1998 PPMC Yearbook. Sherlock Company, 1998, p. 3, 7.33 PPMC(newsletter). Sherlock Company. May 1998.34 PPMC. Sherlock Company, June 1999, p. 2.
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practice management business to focus on hospitalist practices and practice
networks management.
MedPartners, once the largest PPMC, announced its intent to divest it practicemanagement business in November of 1998 stating that the industry is
viewed unfavorably as presently configured.36
The PPMC suffered a loss of
$1.2 billion in the fourth quarter of 1998.37 On March 11, 1999 a voluntary
bankruptcy petition was filed by the conservator for MedPartners Provider
Network and a settlement was reached with the State of California in April
which provided for the orderly disposition of existing California operations.38
PhyCor, once the second largest PPMC, announced at the beginning of theyear that it did not plan on purchasing physician practices in 1999.39 The
PPMC lost $111.5 million in 1998 on revenues of $2.9 billion as compared
with a $3.2 million dollar loss in 1997.40
The number of publicly traded PPMCs had fallen to 22 by June of 1999.41 The number
of PPMC acquisitions of physician practices has declined in the last year and will
probably continue to decline in the short term. However, PPMC business strategies and
market positions vary considerably and the outlook is not entirely bleak. Single specialty
PPMCs are a potential notable exception to the current trends.
C. Hospital transactions
Hospitals purchase physician practices in order to further integrate with
35 How FPAs implosion buried its doctors by Robert Lowes. Medical Economics, Jan. 25, 1999, p. 141.36 Ibid, May 1999, p. 3.37 Ibid, March 1999.38 Ibid, June, 1999.39 Medical Economics, Jan. 25, 1999.40 PPMC. Sherlock Company, April 1999.
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physicians, to strengthen referral relationships, to add physician reimbursement to
their earnings pool, and to increase managed care contracting leverage. Since
1994, hospitals have acquired 5,000 doctors primary care practices per year,spending $100,000 per physician on average.42 A 17-hospital survey by Coopers
& Lybrand found that, on average, hospitals were incurring annual losses of
$97,000 per acquired physician due to high purchase prices and low
productivity.43
Another recent survey based upon 382 practices that were
acquired by hospitals between 1993 and 1996 revealed the following44:
Average physician salary paid was $154,464. Average forecasted profit in first year per physician was -$11,134.
With such losses recorded and poor strategic gains, hospitals are less likely to pay
high amounts for additional medical practices. Tenet Healthcare Corp. and
Columbia/HCA, the two largest hospital management companies, have both
stated that they are considering divesting physician practices.
D. Cost Containment-Regulatory Agenda is changing the market terms and
structure of practice transactions.
2. Tax Code - Increased scrutiny of 501(c) 3 status has affected the marketfor selling practices to charitable institutions, e.g., hospitals, foundations.
a. The primary concern is that the private benefit and private
inurement standards are fulfilled, along with other structural and
community benefit requirements. A sampling of relevant issues
41 Ibid.42 Hospitals that gobbled up physician practices feel ill. Wall Street Journal. June 17, 1997.43 Ibid.44 The 1997-98 Physician Practice Acquisition Resource Book. Center for Healthcare Industry PerformanceStudies, 1997, p. 4, 55, 65, 230.
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